, Research Paper
Internationalization of Accounting Standards for Consolidation
Japan: A Case Study
The purpose of this paper will be to examine problems with internationalization of accounting standards for consolidations on methods from an international perspective – specifically, in the US and Japan. This is an especially timely topic as standardization of financial markets is a prerequisite to international free trade. Given the trends toward greater globalization, the motivations of companies for seeking a uniform accounting system are strong. If companies have to prepare their accounts according to several different sets of rules, in order to communicate with investors in the various capital markets in which they operate or for other national purposes, they incur a considerable cost penalty and feel that money is wasted. This significantly limits global opportunities for multinational businesses. Thus, it is important to understand what the differences are between accounting standards, why they exist, and what problems they pose.
It is worth noting that no one nation has a set of accounting rules which appears to have such clear merits that they deserve adoption by the whole world. No one country can claim to have a uniquely correct set of rules. The United States has the longest history of standard setting. It has the largest standard setting organization which is characterized by high standards of professionalism. But, even the rules of the United States exhibit compromises between different interests of a kind which could have reasonably been decided otherwise. Furthermore, no unanimity exists among U.S. accountants about the merits of the precise details of the compromises that have been struck. For example, the recent discussion memorandum on consolidation outlines three different methods which are GAAP in the US (Beckman, 1995). No one nation has a clear right, on the basis of existing achievements, to be regarded as predominant in accounting. A great deal more work is needed by accountants from different countries before we can reach the point of having a well founded basis for uniformity.
People who study differences among systems of accounting rules are inclined to group countries into two categories. On the one hand, there are countries where business finance is provided more by loans than by equity capital, where accounting rules are dominated by taxation considerations and where legal systems customarily incorporate codes with detailed rules for matters such as accounting. The effect of taxation systems can be particularly pervasive. Often, the taxation system effectively offers tax breaks for businesses by allowing generous measurement of expenses and modest measurement of revenues on condition that these measurements are used for general reporting purposes. Companies have strong incentives to take advantage of these taxation concessions as real cash is involved. But the penalty is a jack of full transparency for investors. Major countries in this category include France, Germany and Japan( AAA, 1995).
The other group of countries is one in which equity sources of finance are more important, accounting measurements are not dominated by taxation considerations as tax breaks can be enjoyed independent of the way result are reported to shareholders, and common law systems prevail. These countries generally have some private sector system for setting accounting standards, often with a general statutory framework. The role of equity finance is important because capital market pressures are then brought to bear most strongly to improve the quality of information available. The absence of detailed codes leaves flexibility to respond to pressures. The United States, the United Kingdom, Australia and the Netherlands are examples of countries in this category (AAA, 1995).
US consolidation policy begins with a definition of control. It is based on the simple legal concept that the majority shareholder controls a company and that even without a majority, a stockholder can exert significant influence. Thus, consolidated financial statements reflect the financial position and results of the firm as well as all subsidiaries upon which the firm may exert this influence. Furthermore, the entity about which the consolidated financial statements are prepared is not an entity in legal form. It is an abstraction created solely for the purpose of these statements and does not have an ongoing set of books as a normal corporation would (Beams, 1992). The details of consolidation in the US are based on one of two theories as outlined in the Discussion Memorandum. The economic unit theory considers the consolidated group to be one economic entity for financial accounting purposes. Thus, the full fair market value of the subsidiary’s net assets at the date of acquisition as well as the minority interest in those assets are included in the consolidated financial statements. The parent company theory holds that only the parent company’s shareholders’ ownership interest should be reflected. There are many more detailed controversies in US accounting for consolidations, but this illustrates how even the US, with the most developed set of accounting standards in the world can have disputes about the most fundamental aspects of consolidation (Beckman, 1995). However, because the US has been the first to conceptualize accounting for consolidations, our form has come to be accepted by the international financial community (Lowe, 1990). While this may be good for us because our method of consolidation is consistent with our culture, it does have some negative effects on the substance of reporting in other countries with incompatible cultures.
Japan is an excellent example of how the international acceptance of accounting standards can actually lower the value of the information provided if the standard is incompatible with the culture of the country. The Japanese began to use consolidated financial statements at least half a century later than many of the other industrialized countries of the world. Responding to external pressure they reluctantly adopted the accounting practices applicable to consolidated reporting employed in the United States and have made a determined effort to adapt them to their own business environment (McKinnon, 1984). The results, however, have been terrible. While US GAAP for preparing consolidated financial statements recognizes groups based upon the legal relationships arising from the majority ownership of voting shares, Japanese corporate groups tend to form from substantive relationships of a non-legal nature. The nature of Japan’s corporate group associations reflect that nation’s cultural and historical interpersonal and intergroup relationships (Lamb, 1993). These corporate related entities deal with each other much in the same manner as we in the United States expect of parent and subsidiary company groups. It is because of this kind of special relationship that we in the U.S. insist upon consolidated reporting. But because Japanese groups are often not connected through legal ownership they are not consolidated. Instead entities with weak relationships are consolidated because they are tied together legally (Lowe, 1990). Consequently, American users of Japanese consolidated statements assume they are analyzing the financial position and results of operations of a group of companies operating as an economic entity. Actually they may be analyzing something quite irrelevant because the statements do not represent the substance of the actual business relationships. This obviously impairs the ability of readers to make appropriate judgments from these statements.
The Japanese form of business grouping is called the keiretsu. This term indicates a grouping or alignment when stockholder control is formally lacking. It enables companies to share risk and allocate investment to strategic industries (Lamb, 1993). Lowe outlines the characteristics of a keiretsu:
(1) Members are all “independent” major firms in their own oligopolists industries. (2) The keiretsu is a confederation of firms excluding competition but aiming at representing all lines within the confederation
(3) Service firms such as banking, trading, insurance and shipping companies from within the keiretsu perform special functions for industrial member firms to the complete exclusion of outsiders.
(4) Between the firms there are many cross ties. Examples are borrowing from the same bank, mutual shareholdings, interlocking directors, using the same trademark, or selling their products through the same trading company.
(5) The presidents of each member firm meet together once a month and discuss matters of mutual interest to the member corporations. These are backed up with meeting of directors and of upper level managers.
(6) Interfirm business within the group has a high priority.
(7) Holding companies at the top are prohibited so the relationship between the firms in these groups is based on cooperation not control as would be the case in the U.S.
Each of these groups is centered around a bank and includes a trading company, a real estate company, an insurance company, and numerous other companies each performing a special function useful to the group. For example, the Mitsui Group includes the Mitsui Bank, Mitsui and Co. (Trading Co.), The Mitsui Real Estate Company, The Tashio Marine Insurance Company, The Mitsui Life Insurance Co., the Mitsui Chemical Co., et al. Each of these major companies has from a few to hundreds of affiliated firms many with small and others with large intercompany stockholdings. Each also holds a small fraction of the outstanding voting shares of the other “parent-like” firms in the group. This is not done for control purposes but to create good relationships and stimulate the feeling of interdependence. It is difficult to determine the size of these corporate groups. They exist as a matter of fact but not as a matter of record. Sales, net income, or asset information is not published on a group basis (McKinnon, 1984).
Each company may own up to 10 percent of each other’s voting shares but none has voting control over any of the others. Human ties within the group insure the cohesiveness through intercompany meetings, interlocking directorates, and transfers of personnel. It is difficult for the typical American to understand the forces which bind together on a stable and permanent basis a group of corporations of the type described (Lowe, 1990). If legal control by a parent is not present an American would say a stable group does net exist. However, this is perfectly rational for a person reared in the Japanese culture and tradition. The vital factors in the maintenance of the keiretsu are the generally recognized characteristics of group consciousness and interdependence.
Japanese consolidated statements patterned after American standards have survived only because foreign users have been largely unaware of their inappropriate focus and innocent misrepresentation. No financial statements yet developed are capable of dealing with the typical Japanese sphere of influence concept of economic interdependence (McKinnon, 1984). Parent-company only financial statements do alert readers to the fact that they are seeing only a segment of the financial position and results of operations of the total economic entity. Consolidated statements prepared in such circumstances have the serious weakness of tending to mislead users into believing they are getting a full picture of the group when obviously they are not. Many of the most important firms affecting the future fortunes of the group are not even represented in these statements.
Cultural and historical influences provide significant contrasts between corporate group associations and corporate behavior in Japan and the United States. Evidence of these contrasts in Japan are found in the stable ownership of a majority of the shares, the decentralized cross-holding pattern of share ownership, the predominance of small shareholdings, and the importance of non-share ownership criteria as a basis for forming corporate groups. The corporate group associations tend to be maintained by the cultural characteristic of group consciousness with a strong orientation toward interdependence. The notion of control through direct or indirect majority share ownership and the presence of a holding company or a dominant parent company are foreign concepts to the typical Japanese executive. Share ownership is generally regarded as of minor significance in the forming and maintaining of corporate groups. Consequently, American practices of consolidation tend to group Japanese corporations in a manner contrary to their normal functioning. Such practices tend to break up the complex and dynamic reality of the natural groups into American-type corporate groups attempting to portray an American perspective to something uniquely Japanese.
Japan’s experience with consolidated statements pinpoints an unexpected problem associated with the process of harmonizing accounting standard. All nations have their own peculiar cultural features. It is expected that each country will make an effort to harmonize its own financial reporting methods with international reporting standards in order to make its reports more useful to foreign users. But it will do so only as fast as it is able to reconcile these standards with its culture. In contrast to this, Japan adopted harmonizing consolidated reporting standards without reconciling them with its culture and it attempts to apply these standards meticulously. Consequently, its unique business organizational structure often makes its consolidated financial report less rather than more useful to readers.
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